How is my deferred compensation taxed?

Dan Moisand,
a Principal at Moisand Fitzgerald
Tamayo, LLC in Melbourne and Orlando, Fla., is one of the financial
planning profession’s most respected practitioners advising retirees and near
retirees. Dan’s thoughts can be found in bylined articles in most major
publications for financial planners and a slew of financial planning related
publications have featured him as one of America’s top advisors and was recently
named one of
"15
transformational advisers" by InvestmentNews. A past national
President of the Financial Planning Association (FPA), his service to the
profession includes three years on the CFP Board of Practice Standards crafting
the standards to which all US CFP’s must adhere and serving as Chairman of the
CFP Board’s Discipline and Ethics commission, the body that judges complaints
against CFP licensees. A frequent presenter at such events in the U.S., Dan has
spoken to planner groups on five continents and in recent years has led
delegations of U.S. planners to Russia and China on behalf of the FPA.

Using a deferred-compensation plan can be an excellent tax strategy but not all deferred compensation plans are the same. This week, I try to explain why one reader's tax bill was higher than expected.

Q. I'm now retired and of course have to pay taxes on my deferred compensation as received. Here is my question, I realized I would have to pay federal and state taxes on my deferred comp. However I never realized that I would have to pay self-employment taxes for I always earned over the Social Security thresholds and never saved any SE taxes on my deferred comp. Last year I had to pay over $6,000 on SE taxes even though I'm retired and age 67. My CPA said this is due to the 1099 misc form that is reported to the IRS each year. Just wanted to know if this is correct, or any suggestions. Thank you. — Richard

A. There are many forms of deferred compensation but based on your description and your CPA's endorsement, it is probably correct.

Deferred compensation means exactly that. You put off receiving earned income until a later date. Deferring income can be a good move if the party paying the compensation is healthy enough to be around to make the payment and you get a tax benefit. The tax break comes if the tax rate that applies later when you receive the funds is lower than the rate you would have paid at the time the compensation is earned.

Certain deferred compensations plans have rules for payroll taxes that can result in these taxes being due when the compensation is paid.

You mentioned the income came as 1099-misc and was subject to self-employment taxes. For 2014, in addition to regular income taxes, net self-employment income is subject up to 15.3% of self-employment taxes. The 15.3% is composed of 12.4% tax for Social Security (on the first $117,000 — the Social Security wage base) and 2.9% for Medicare taxes. Amounts above $117,000 are only subject to the 2.9% Medicare taxes. If income is high enough, an additional 0.9% Medicare tax is payable on top of the 2.9%. No limit applies to the amount of net self- employment income subject to Medicare taxes.

You also mentioned that while working, you always earned more than the Social Security wage base, so had you not deferred, this income would have been subject to less self-employment taxes but probably more in income taxes. Your case serves as an example of why readers considering deferring compensation should factor in the timing of payroll taxes.

Q. I am retired and have a deferred comp acct. I want to know if the taxes I pay on this account (10%?) can be claimed as income tax and if I can file a return to hopefully get some of this money back the year that I take the money out, and file my Income tax return. Thank you — C.A.

A. C.A., if the withholdings you reference are for income taxes and you had withheld more than you actually owed for the tax year, you would receive a refund for the overpayment. This would be determined when you file your tax return.

If any of that 10% is for payroll taxes (FICA, Medicare), similar to the question above, they are likely not refundable. Employees that receive wages reported on a W-2 pay 7.65% and their employers also pay 7.65%. Self-employed people are considered both employer and employee, hence the 15.3% (7.65% X 2).

You aren't self-employed so only the employee portion of the payroll taxes would be due. Your employer pays the other half. So, only up to 7.65% of the 10% could be nonrefundable.

Q.If a person is drawing Social Security early, retirement from a job two years ago and in the current year exercises their non-qualified stock options that are reported on a W-2, will that cause them to have to pay back Social Security. I have read articles (including those on the ssa.gov site) and seem to come to two different conclusions. — L.T.

A. No. One wouldn't have to "pay back" Social Security. However, persons receiving Social Security benefits before their full retirement age (FRA), that receive W-2 wages are subject to reductions in their Social Security benefits if their wages exceed $15,480. In the year a person reaches their full retirement age, reductions kick in at $41,400 and there is no earnings limitation beginning the month that person reaches their FRA.

Q. Hello Dan. I turned 66 in Sept and collected my full Soc. Sec. Oct. Nov. Dec. Of 2013. I worked until 12-27-13 Soc. Sec. $2.335.00 per month. Job for 2013 $70.000. Pension for 2013 $3000. I was told I now have to pay back some of the Soc. Sec. That I collected because I made over $34.000. I thought that once I was past my full retirement age of 66 I would not have an income penalty. I know I need to pay taxes but this is the first I have herd of the give back ... Thanks in advance for your answer. — Harry

A. I'm not sure what is meant by "paid back,” Harry. If you started your benefits in September, no reductions due to earnings are applicable because you reached your FRA. If you started before your FRA in 2013, a reduction of $1 for every $3 you earned over $40,080 was applicable but the reductions are supposed to cease once you reached your FRA.

That $34,000 number stands out to me though because once a single person reaches $34,000 in combined income, up to 85% of Social Security can be taxable as ordinary income. If you had nothing withheld for taxes from your Social Security benefits, you may need to pay some taxes when you file.

Q.Hi Dan, I will turn 66 this summer, and plan to file for my SS benefits. I will be working part time at best, but my wife is still working full-time. Will her income negate my SS benefits, and make it necessary for me to pay taxes on my benefits? Thanks — P.G.

A. There are two separate issues here; the effect of working on Social Security payments and the taxation of Social Security payments.

The work related reductions are per individual. Your wife's income has no bearing on whether your benefits are subject to a reduction. You will be past your FRA, so you can work as much as you like with no effect on your benefits.

Wages for either one of you are a factor in how much income tax you pay on your benefits. The higher your combined income, the more Social Security payments are taxable. The numbers vary based on your filing status. Assuming you file jointly in 2014, if your combined income exceeds $44,000, up to 85% of your Social Security payments are taxable. "Combined income" is your adjusted gross income + non-taxable income + ½ of Social Security benefits.

Editor’s Note: Dan Moisand answers reader questions on all things retirement every Friday. If you have a question for Dan, please email him at RetireQA@marketwatch.com

Dan Moisand's comments are for informational purposes only and aren't a substitute for personalized advice. Consult your adviser about what is best for you.

The rise of bitcoin has triggered a lively debate over the risks and rewards of virtual currencies. If you’re interested in bitcoin, and will be in New York on Tuesday, March 4, you’re invited to join us for an evening of cocktails and conversation on the topic. MarketWatch Senior Columnist Robert Powell will moderate a panel discussion with guests Todd Harrison, founder and CEO of Minyanville Media; Phil Rapoport, director of Markets and Trading at Ripple Labs; and Mark T. Williams, a banking and risk management expert and a professor at the Boston University School of Management. This MarketWatch Investing Insights event is free, but space is limited. To attend, just RSVP to MarketWatchevent@wsj.com by Friday, Feb. 28.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information. Intraday data
delayed per exchange requirements. S&P/Dow Jones Indices (SM) from Dow Jones & Company, Inc.
All quotes are in local exchange time. Real time last sale data provided by NASDAQ. More
information on NASDAQ traded symbols and their current financial status. Intraday
data delayed 15 minutes for Nasdaq, and 20 minutes for other exchanges. S&P/Dow Jones Indices (SM)
from Dow Jones & Company, Inc. SEHK intraday data is provided by SIX Financial Information and is
at least 60-minutes delayed. All quotes are in local exchange time.